Put Alcoa's Spinoff on Your Watch List

Aluminum maker Alcoa (AA), down 41% year-to-date, is starting to attract attention from contrary-minded investors. They’re misguided – it’s foolish to buy a stock just because it’s gotten crushed. But they’re actually on the right track (albeit for the wrong reason), because Alcoa’s ugly duckling business is likely to deliver beautiful swan stock returns.

The corporate spinoff – where a company splits into two (and sometimes more) new publicly traded firms – is barely a blip on the radar for many first-level investors. They prefer to fixate on its much-ballyhooed cousin, the IPO.

That’s too bad for them, because while hot new offerings may pop for big gains out of the gate, they’re equally likely to erase those gains—and more—once the hype dies down. They’re also much more likely to be overpriced at the outset. The ignored spinoff is where the real returns are at.

IPOs Sink, Spinoffs Outperform

So far, this has been a tough year for spinoffs, with the Guggenheim Spin-Off ETF (CSD)—a reasonable proxy for their performance—down more than 15% year-to-date, compared to a 7% decline for the S&P 500.

But it’s been an even rougher year for IPOs: as of Monday’s close, the
Bloomberg IPO Index, which tracks the performance of stocks during their first year of trading, was down 26.6% since the start of 2015.

Of course, a single nine-month period is largely irrelevant from a long-term investor’s point of view. Luckily for us, there are studies available spanning longer timeframes. In 2013, for example, researchers at the University of Florida released a study looking at what IPOs between 1970 and 2011 returned in their first five years as publicly traded companies.

The findings? IPOs underperformed other firms of the same size (judged by market cap) by 3.3%, excluding the first day of trading. When you zero in on the latest 11-year period, that gap narrows to 1.8%—though IPOs trailed by an especially glaring 18.0% in Year 1.

Meantime, a 2012 Credit Suisse study that focused on the top 1,000 US companies by market cap tells a different story on spinoffs. It looked back over the preceding 17.5 years and found that spun-out firms outperformed the S&P 500 by 13.4% in their first 12 months as public companies, while parents topped it by 9.6%.

Lots of Spinoffs—and Plenty of Time to Choose

There are plenty of reasons why a company may go the spinoff route, but a common one is that the move sharpens management’s focus. The teams in charge of both new firms can zero in on their main businesses instead of juggling a mixed bag of operations that often have little in common.

Companies are also responding to a long-term shift in investor demand from conglomerates to pure plays. Activists are playing a big role here, too, pushing more companies to separate out faster-growing operations so they’ll be easier for the market to see—and value—than if they stayed buried within a conglomerate.

These factors are driving the number of spinoffs to historically high levels: by the end of 2015, research firm Spin-Off Advisors predicts 51 companies will have announced breakups. That’s down from 60 last year, but it still marks the third-highest total in the past two decades, behind 1998 and 1999 (66 apiece) and 2014. It’s also up from 37 in each of 2012 and 2013.

This means that second-level investors have lots of time after a split to research these companies for themselves before taking action.

In his 1997 book, You Can Be a Stock Market Genius, hedge fund manager Joel Greenblatt cited a 1993 Penn State study showing that on average, spinoffs beat the S&P 500 by 10% a year through the first three years—though the biggest gains came in Year 2.

The Credit Suisse study also indicated an adjustment period: it found that spinoffs trailed the S&P 500 during the first 28 days before moving ahead of the benchmark, while parent firms took 27 days to do so. By day 60, both the parent and spinoff had returned on average 2.2% more than the index.

If you think about it, this makes sense: suppose you’re an investor in XYZ Co., and you receive shares of its newly spun-off widget division. You didn’t pick the stock yourself, so you may decide it’s not the best fit for your portfolio. The result? A higher chance you’ll unload it—and probably within the first year.

Turning a Duckling Into a Swan

Here’s something else most investors miss about spinoffs: it’s often the unloved, or “boring,” stock that turns out to be the better investment.

A good example is Abbott Laboratories’(ABT) January 2, 2013, separation of its pharmaceutical business, Abbvie Inc. (ABBV), into a new public company.

“Some saw Abbvie’s products as dead weight, begging to be jettisoned so that Abbott’s faster-growing diagnostics and nutrition business could soar,” wrote Fortune magazine reporter Jen Wieczner in a June 29 article.

But nearly three years and a number of successful drug launches later, Abbvie has run circles around its former parent, returning 56%, compared to just 27% for Abbott. Abbvie also boasts a higher dividend, offering a 3.9% yield, compared to 2.5% for Abbott.

That brings us to the latest split to hit the news: Alcoa Inc.’s(AA) separation of its faster-growing engineered-products business from its aluminum-production operations, which have struggled in the face of a persistent aluminum glut. The transaction is slated for the second half of next year.

Will we look back three years later and see the same pattern we saw with Abbvie and Abbott?

Time—and the aluminum market’s supply/demand balance—will tell, but I wouldn’t be surprised if that’s how things play out. Put Alcoa’s future spinoff on your watch list.

And there’s another new spinoff that’s a great buy right now. It’s cashing in on one of the strongest trends affecting our society today, plus it boasts a safe 7.3% yield—and we expect its payout to double in the decade ahead.